Euro-Zone: More Break than Make?

Euro-Zone More Break than Make?
Satyajit Das
December 9, 2011


European summits – over twenty at last count – have produced little. The planned summit on 8/9 December 2011 may well be the last chance for Euro leaders and Euro-crats to avoid a financial disaster. Given that European leaders cannot overcome their common sense deficit, which is proving as intractable as budget and trade deficits, this may not end well.

The last comprehensive and final plan – the fourth in the last 18 months – failed to mollify investors and markets. The crisis is now engulfing Italy, Spain and now re-infecting Ireland and Portugal. Stronger countries like France (at risk of losing its AAA credit rating) and Germany are increasingly vulnerable.

Standard & Poor’s is reviewing the ratings of a number of 15 Euro-zone countries with negative implications. This action was “prompted by … belief that systemic stresses in the Euro-zone have risen in recent weeks to the extent that they now put downward pressure on the credit standing of the Euro-zone as a whole.” The rating agency highlighted tightening credit conditions across the Euro-zone, higher funding costs for many Euro-zone sovereigns, high levels of government and household indebtedness, the rising risk of an European recession and a lack of agreement among European policy makers on tackling problems.

Critical Points…

The curious pas de deux between European banks and sovereigns has reached a critical stage. Needing to raise money and keep interest costs down, governments are pressuring banks to buy their bonds and use them as collateral to raise fund from central banks and the European Central Bank (“ECB”). At the same time, European banks exposed to the risk of large losses on holdings of sovereign bond, which would render them potentially insolvent need governments to support the banking system.

Time is running short. European Sovereigns and banks need to find Euro 1.9 trillion to re-finance maturing debt in 2012. Italy alone requires Euro 113 billion in the first quarter and around Euro 300 billion over the full year. European banks need Euro 500 billion in the first half of 2012 and Euro 275 billion in the second half. This means they need to raise Euro 230 billion per quarter in 2012 compared to Euro 132 billion per quarter in 2011. Since June 2011, European banks have been only able to raise Euro 17 billion compared to Euro 120 billion for the same period in 2010.

There has to be acknowledgment that austerity – draconian budget cuts and tax increases – to bring budget deficits and public debt under control cannot deal with the problem – the deflation of the debt-fuelled bubble. There also has to be acknowledgment that Europe doesn’t have a “liquidity” problem which can be alleviated by substituting fleeing private sector lenders with official lenders such as the European Union (“EU”), ECB or the International Monetary Fund (“IMF”).

The European Financial Stability Fund (“EFSF”), the European bailout fund, is now largely irrelevant, It lacks the resources to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from contagion. Schemes to increase the capacity of the EFSF – borrowing to leverage the fund or partial guarantees or seeking Chinese funding – are simply far fetched or incomprehensible. The EFSF’s attempt to raise money to meet existing commitments has run into problems, meeting lack lustre support and a sharp increase in costs.

In the event that the AAA guarantors are downgraded, the EFSF structure, as originally envisaged, becomes unworkable. Rating agencies have signalled that the EFSF’s AAA rating is under threat. The risk that the cost of funding for the bailout fund is greater than the rate that it can charge is now increasingly evident.

European countries have a “solvency” problem – they have debt that they can never seriously expect to pay back. Stronger nations cannot save the peripheral nations without ultimately destroying their own credit and ability to raise funds.

Commonly touted solutions, such as fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies) or debt monetisation (the ECB prints money) are unworkable.

Germany and France are unwilling or unable to increase the size of their commitments. Restricted by the German Constitutional Court’s decision, for the moment, Germany cannot or will not go above Euro 211 billion in guarantees for the bailout funds already committed –about 7% of its GDP. Fiscal integration would have a higher cost than Germany is willing to pay or can sustain without affecting the country’s creditworthiness.

France is at the limit of its financial capacity and at risk of losing its AAA credit rating. Fragile coalition governments in Netherlands and Finland are increasingly reluctant to increase their commitments to the bailout process. These constraints make full fiscal union difficult.

Stronger European countries have seen a sharp increase in the cost of their financing. Netherlands 10 year debt is trading around 0.40% above Germany, down from a November high of 0.68% but well above the 0.10% where it traded historically. Austria’s 10 year rate relative to Germany fluctuated between 0.80% to 1.90% in November, up from an average of 0.23% over the last 10 years. Finland’s 10-year spread to German bonds reached 0.79% in November, well above the low of 0.07% in January 2011 and an average of 0.35% over the last year. Finland’s 10 year bonds are trading at around 1.00% over that of neighbouring Sweden, down from a high of 1.37% but well above an average difference of 0.04% since the introduction of the Euro in 1999.

The higher rates and increased volatility of rates has made it increasingly difficult for these countries to finance, despite relatively sound public finances. For Finland, where 75% of its debt is sold to foreign investors, this is increasingly problematic.

The ECB is not allowed and also unwilling to print money. Germany’s Bundesbank opposes debt monetisation. The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow the printing of money. This assumes that a cost-benefit analysis indicates that this would be less costly than a disorderly break-up of the Euro-Zone. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation.

Printing money may buy some time. But it does not deal with the level of debt, the problems related to bank holdings of sovereign bonds (a small fall in value may affect the solvency of many institutions), allowing countries to regain access to investors on a sustainable basis or economic competitiveness.

If fiscal union and debt monetisation are unavailable, a “controlled” debt restructuring of some nations may be the only option available.


What happens in Europe will not stay in Europe. The shock will be rapidly transmitted through trade, investment and the financial system to the rest of the world. Problems in international money markets will not be welcome for America businesses and the Federal government, which relies on foreign investors for financing. It may truncate the nascent American recovery.

Not only are their financial health and savings affected by what happens in Europe, if the International Monetary Fund (“IMF”) gets involved American will be bearing around 16% of the bill for any European bailout.

The US and Europe account for around 40% of world GDP and 25% of trade. They also make up around 60% of direct investment flows and 60% of financial assets. Europe and the US is each other’s most important market for goods and services.

In 2010, the EU purchased just over $400 billion worth of US goods and services, around 20% of total exports. US exports to Asia are frequently components of or driven by exports to Europe.

The expected economic slowdown in Europe will affect US exports, one part of the American economy that is doing well growing are around 11%, the fastest rate for more than a decade. The slowdown in emerging markets that trade with Europe will have secondary effects on America’s economic activity.

A September 2011 report prepared by the Congressional Research Services estimated that American banks exposure to Greece, Ireland, Italy, Portugal, and Spain — some of the most heavily indebted euro zone economies — amounted to $641 billion. US banks direct exposure to European sovereigns is around $100 billion. The net exposure is probably lower due to hedges.

Indirect exposure via dealings with banks exposed to Europe is larger. American banks have exposure to German and French banks are greater than $1.2 trillion, about 10% of total commercial banking assets in the United States. US banks also have substantial open derivatives contracts with European banks, face value of around $750 billion although the current value of the positions is much lower.

In case of defaults or debt restructuring of one or more European nations or distress of a major European bank, US banks would suffer both direct and indirect losses, such as failed hedges. MF Global’s losses and bankruptcy are a stark reminder of the risks.

US retirement investments in European securities are at risk. Indirect exposure to losses on European securities is even greater. Around $800 billion of China’s currency reserves are invested in Europe. Losses would reduce this savings pool which would affect China’s ability to purchase US Treasuries.

The problems of European banks, previously active in financing local businesses, will compound the problem. These banks are required to increase capital to cover losses, including those on their sovereign bond investment. As they can’t or do not want to issue equity at deeply discounted prices and the limited investor appetite for such issues, the banks may sell assets or reduce lending to raise the required capital. Estimates suggest that these banks could have to sell (up to) $2.5-3.0 trillion in assets, resulting in a sharp contraction in availability of credit.

While they are not a significant component of lending to American businesses, in 2007, European banks accounted for 30% of loans in Asia-Pacific. This has fallen by around half to 15-16% and is likely to shrink further as a result of the problems of these banks. Troubled French banks account for about 11% of maturing loans in Asia Pacific in 2012. It is unlikely that these banks will maintain their level of commitment. Asia-Pacific banks have taken up the slack but are not sizeable enough to fill the gap completely. The absence of credit will affect Asian businesses, which will then flow through to the US through reduced exports.

Recent action by central banks to lower the cost of US dollar funding via liquidity swaps for non-American banks was designed to alleviate some of these pressures. While they have had some effect, the funding position of European banks remains fragile.

The US will be affected through the appreciation of the dollar against the Euro. The Euro has declined in value by already 5% in a few weeks and further falls are possible. This will reduce the competitiveness of America exports, particularly relative to European businesses. Continued decline in the Euro will have a substantial adverse impact on US exports.

Historically, growth in the two economies is highly correlated. A slowdown in Europe is generally reflected in lower growth in the US reflecting the economic linkages. US growth may slow in response to Europe’s problems.

Stock markets are also correlated. American companies, especially with major European operations, have already signalled lower earnings as economic activity slows. Firm affected includes bellwether businesses like GE and McDonald’s. Automobile companies, with sales of nearly 25-30% in Europe, food and tobacco companies are exposed.

Continued problems are likely damage weak consumer and business confidence affecting the recovery.

American investors and financial institutions have reduced exposure to European debt and investments. The US Federal Reserve has provided dollars via European Central banks to help calm markets and avoid a dollar liquidity crunch. But beyond these measures, Americans are largely spectators to the events in Europe.

Nien or Non…

Early signs are not good. In lead up to the summit, the French President has pronounced that no European country will be allowed to default. Germany placed its faith in more austerity without increasing her financial commitment, proposing a revised treaty between Euro-Zone members to reinforce a commitment to fiscal discipline. Automatic, court-enforced sanctions on countries that exceed 3% of GDP on budget deficits and 60% of GDP on debt are laughable. The bulk of Euro-Zone countries do not and can not meet these limits now or in the forseeable future. As for the proposed fine, they would have to borrow the money to pay them.

Plans to leverage the EFSF are to be tabled, although no one honestly knows whether any investor will support it with cash. The Chinese have said “nein, danke” and “non, merci”.

The ECB predictably reduced slash Euro interest rates and lengthened the term of emergency funding of banks to 3 years with easier collateral rules (they will now accept lottery tickets as security). European central banks will provide money (Euro 200 billion) to the IMF to provide money to beleaguered nations. Details are eagerly awaited but IMF funding would rank above ordinary creditors and impede the receipt’s access to commerical funding complicating the problem.

No restructuring of the Euro is contemplated as the French, Germans and the EU appear hopelessly devoted to the common currency.

There was no attempt to tackle the real issues with the seriousness and sheer financial strength required. But perhaps the reality is that the solution is now beyond Europe’a ability and there is simple not enough money – Euro 2.5 to 3.0 trillion would be required.

Instead, European leaders seem content to discuss long term lifestyle changes with the near death patient in ER.


Satyajit Das is the author of Extreme Money: Masters of the Universe and the Cult of Risk (2011) and Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives – Revised Edition (2010)

© 2011 Satyajit Das All Rights reserved.

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